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Pravin’s Private Equity Poser

Budget Speech time is rapidly approaching and taxpayers will be looking to the Minister of Finance for details on how he plans to fill the government coffers for the 2013 fiscal year.With the National Development Plan top of mind, the roll-out of the National Health Insurance pilot sites imminent and the proposed introduction of a youth wage subsidy gaining momentum, the Minister is going to have to find ways to improve tax collections.

As part of efforts to bolster tax revenues, the budget speech is likely – in part – to reflect a continued focus on regulating transactions that have the effect of eroding South Africa’s tax base.

Leveraged buy-out transactions have been high on the list of transactions that have attracted scrutiny in the past few years. These transactions are often characterised by significant levels of gearing and accompanying interest deductions. The interest deductions result in large assessed losses being racked up by businesses that were in a taxpaying position prior to the buy-out. Where the interest is payable to non–residents, or to residents with a low effective tax rate, the deductions claimed by the borrower exceed the interest taxed in the hands of the lender and the fiscus is worse off.

Legislation was introduced in 2011 to curb these losses. It requires taxpayers entering into so-called ‘reorganisation transactions’ to obtain approval from the South African Revenue Service (SARS) regarding the extent to which an interest deduction can be claimed. The legislation is, however, only applicable to transactions entered into on or after the effective date of the section (3 June 2011 or 3 August 2011 depending on the type of reorganisation transaction) and thus does nothing to stop the tax leakage stemming from the spate of leveraged buy-outs that occurred before these dates.

A number of these transactions were funded by a combination of senior debt and payment-in-kind notes (PIKs) listed on foreign bond exchanges. PIKs generally attract a high interest yield, coupled with an equity return. Interest on PIKs is often only settled on maturity of the instrument. Whilst the interest deductions claimed in relation to foreign sourced senior debt and PIKs is of concern to treasury, the hybrid nature of the PIKs has drawn particular attention.

The 15 percent withholding tax on interest payable to non-residents, which will come into effect on 1 July 2013, may offer some protection to the tax base. However, the provisions in this regard provide for an exemption in relation to debts listed on a recognised exchange. These exchanges include those on which many of the senior secured notes and PIKs are listed. Interest payable on these instruments would therefore be exempt from withholding tax on interest and would remain a drain on the fiscus.

One solution would be to review the list of exchanges that are recognised for purposes of the withholding tax and exclude those where the offending instruments are listed. Any such action may, however, have the effect of excluding non-targeted instruments from the withholding tax relief and could have a negative effect on foreign investment in the South African bond market.

The second and more likely solution is to revisit the provisions in the Income Tax Act that have the effect of tainting the interest return on so-called hybrid debt instruments. The first draft of the 2012 Taxation Laws Amendment Bill proposed far reaching changes to the hybrid debt rules, which could have the effect of deeming PIKs to be equity instruments rather than debt and thereby eliminating any interest deduction that the PIK’s issuer could obtain.

The proposed amendments were, however, overly broad and inadvertently caught non-offending debt instruments in their net. As such, the National Treasury shelved the proposed amendments. The intention behind the amendments was, however, consistent with a further trend whereby the legislators aim to ensure that the tax treatment of debt and equity instruments follows their economic substance rather than their legal form. This can be achieved through careful tweaking of the 2012 proposal.

Any attempt by treasury to limit the interest deductions in relation to historical transactions could have a far-reaching economic impact that must be balanced with the immediate need for revenue collection. Due consideration must be given to the common inclusion of gross up clauses in funding agreements. Any additional costs associated with a change in legislation will inevitably be borne by the issuer and these companies, already burdened with high interest bills, could be crippled by the costs brought on by the gross up clauses.

Treasury should also consider the economic impact of the approval process for reorganisation introduced in 2011. Where SARS does grant an interest deduction on foreign funding, the percentage allowed is a fraction of the overall interest charge. Companies embarking on reorganisation transactions are disincentivised to source foreign debt and the country ultimately loses out on much needed foreign investment.

The 2013 budget therefore requires a careful balancing act by the Minister. The funding requirements of the various facets of the National Development Plan are, however, going to result in increased collection efforts by SARS so taxpayers will need to be increasingly vigilant of their compliance with tax legislation. Given the complex and ever-changing nature of this legislation, the role of skilled tax professionals in guiding taxpayers cannot be underestimated.

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